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Software, Satta and Sighs - Views on News from Equitymaster
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  • Apr 15, 1998

    Software, Satta and Sighs

    The Software satta has not only taken America by storm, but seems to have captured the imagination of every front-running Indian punter on Dalal Street. That accounts for that part of my title that has "software" and "satta" in it. But then where does the "sighs" part of my title fit in? Ah, the "sigh" is that part of me which wishes that I was in the know of things in these stocks and had not missed out on the fantastic run-up in these companies!

    But I have missed it. And what a mistake it has been. A very expensive mistake. My fascination with software stocks began a few years ago in India (Infosys, Mastek, and BFL) with the basic story: Indian brain power is cheap relative to the world, someone needs to do all the grunt work in the sexy world of software, and that the someone will be the Indians. I never believed that the software companies in India could actually make products (still do not) and felt that they would be the back-office boys to the glory seekers. Nothing wrong with that - still very profitable business.

    That theory worked okay for a while. When stocks of Indian software companies began to show up on the decimal point screens of fund managers, the first run-up began in 1994 and 1996. Large amounts of money got into very thinly traded stocks (over 50% in most cases held by managements, like the multinantionals) and share prices hit new highs pretty quickly on trading volumes of 5,000 shares.

    Of course, the run up in share prices resulted in some managements launching new software ventures and IPOs. These stocks languished for some time due to the perception that these managements were questionable. But all that is history now and the share price of every software company is moving into uncharted territory. The volumes have remained about the same but the trading value of the shares has doubled or trebled because the per share price has risen.

    Imagine, the market cap of some of the Indian software firms is now more than that of ACC. The foreign brokerage houses have finally figured out that if they can print 50 pages of research every year on ACC, they sure can print 100 pages of research reports on Indian software companies and generate more broking commissions from the FIIs. And that is where I believe the danger lies. Most of the anlaysts are showing market caps of similar stocks in USA and Singapore and Europe as comparison and justification for the high PERs that the Indian software sector enjoys. If PE ratios of software companies around the world are at 45x, why can't the Indian software companies trade at 25x? That is the same argument that was used for real estate prices by the real estate developers and investors just 3 years ago. And look where they are today.

    The very benchmarks that were used to compare real estate prices against, collapsed. Never mind the fact that most of Nariman Point is a slum in comparison to the benchmarked pricing of real estate in Singapore and Hong Kong. But real estate is a fixed and immovable asset and software engineers (the real wealth of a software company) are moveable and mobile people - so why am I comparing the two? The first reason is to show that benchmark comparisons are not the only reason to pay good money for a share. And, secondly, to highlight the fact that the asset of the software companies is its people (as the asset of the Taj and Oberoi hotel chains is their bank of rooms). The rooms of the Taj and the Oberoi cannot walk out and migrate to the United States. The software engineers can walk out.

    And now they can do more than walk, they can fly! Lobbying by business folks in the US enables American companies to hire 115,000 foreigners in 1998 under an H-1 visa (a temporary work visa) up from 65,000 in 1997. This 50,000 increase is meant to alleviate the shortage of around 250,000 engineers that the US has. In the years 1999 and 2000, the H-1 quota is 95,000 each year. A quick calculation suggests that all the leading IT companies in India probably have around 20,000 employees. What if all those 20,000 software engineers just pack up and take off for the US? In India, the average salary of a software engineer is probably Rs 20,000 per month and they have to commute in dusty roads to get to work. In the US, they will be paid probably Rs 120,000 per month and won't have to worry about gas connections, power shortages, and dusty roads. The US has a habit (a good one) of making sure that all key ingredients to get its economy moving are freely available and inexpensive. Oil, hand guns, metals, beer and food are all pretty cheap in the US. If a shortage of any key input that keeps their economy humming along looks like it is going to be a problem, the US makes sure it no longer is.

    If technology engineers are scarce, they import them. They did it to the doctors and IIT graduates in the 1970's, the MBA's and accountants in the 1980's and now they are wooing the technology folks. And if the Indian technology companies wish to keep their good guys, they will need to increase salary levels dramatically (stock options are also given by US companies so that alone will not retain the good folks). And if they do that, the comparative advantage of inexpensive rain-power will decrease. It is a tough call to make, but probably one to think about. I wish I had those software stocks so I could sell them to someone who wants them. Sigh.



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